Uncertainty is the lack of clarity about the future. However, in order to understand what the future holds in periods of uncertainty, it is important to understand the components and characteristics of uncertainty, and what factors are driving economic uncertainty. When bad news arises, many things come into play simultaneously. Demand, supply, investment and a vast array of other factors play a part in an economic downturn.
However, people simply describe the current predicament as uncertainty without knowing which components are playing a part in the uncertainty factor. People simply and lazily label the predicament as ‘economic uncertainty’ without analysing exactly what this is, hence the various inaccuracies by leading officials in the immediate aftermath of the Brexit vote. Statistically measuring and analysing uncertainty allows for a much clearer conclusion as to which areas, taking into account all aspects of economic activity, are playing what part in economic changes and hence provide a forecast on the economic outlook. Therefore, the outlook becomes much less uncertain.
The Importance of Measuring Macroeconomic Uncertainty
Why is this measurement so important? The answer lies within every functioning part of the economy. In the case of businesses, for example, information on spending and investment, demand and supply is necessary for everyday decisions, rather than a ‘wait and see’ policy which results in inactivity and missed opportunities. Therefore, information on uncertainty provides the platform to ascertain the sources of uncertainty which is important for the measurement of risk, supply and demand factors, inflationary pressures, and the forecasting of other important macroeconomic indicators.
The aim of this form of measurement is to replace unknown information with known information. An example for the requirement for a fundamental understanding for forecasting under uncertainty lies in the immediate aftermath of the Brexit vote where the general consensus was that there would be an instant slowdown in activity. This proved not to be the case, however, more precise information about the economic indicators of interest was needed, and this is when it becomes paramount to understand the characteristics and sources of uncertainty.
Tracing the Path After an Uncertainty Shock (Brexit)
In order to better understand how economic uncertainty affects the economic system, economists use a statistical test referred to as an Impulse Response Function (IRF). This is simply a test to ascertain how an economic shock affects economic indicators in terms of (i) the strength of the shock, often referred to as the magnitude or impact (or the highest point of the curve in graphically illustrated terms) and; (ii) the duration of the shock (i.e. how long does the shock affect the economy before the effects of the shock begin to die out). The benefit of this is to use the results to determine, for example, the length of time it may take for an uncertainty shock to affect the real GDP growth rate. Economists can also discover if the shock has a positive or a negative impact on the real GDP growth rate and the extent to which this shock is relevant to other indicators such as inflation and interest rates.
Figure 1 shows the reaction of the UK real GDP growth rate to a single uncertainty shock. The single solid blue line shows the path from the initial shock at point zero. The time scale is denoted in quarters and is shown on the x-axis with the per cent change on the y-axis. The dashed orange lines are denoted as upper and lower bands, and these do not straddle the x-axis, indicating that the results are reliable. Here, the UK real GDP growth rate shows a small increase in the first quarter, followed by a decline in the following three-quarters before the effects of the shock begin to die out.
The small increase in the immediate period following the shock can be explained by the fact that companies must still follow through on orders made prior to the shock. The growth rate here is indicated by the small increase in quarter one. The impact (or magnitude) of the increase remains small as economic uncertainty would have existed prior to the shock itself, the Brexit vote, giving rise to the ‘wait and see’ policy which took place before the shock.
Figure 2 illustrates the path of the UK inflation rate following an uncertainty shock. The results show that for one-quarter in the immediate aftermath of the uncertainty shock, there is no change in the UK inflation rate. In the following three-quarters, the UK experiences an increase in the inflation rate, indicating the potential action for central bank monetary policy intervention. An explanation for the increase in the inflation rate is that once uncertainty occurs, investors switch instruments from uncertain economies to less uncertain ones, for example, in term of currency held. In the UK, sterling may fall significantly against a basket of trading partners and as such, should signal the start of an increase in exports. However, as UK companies adopt a ‘wait and see’ policy, orders for exports are not filled at the same momentum as the pre-shock activity and as such, companies do not export as they might be expected to. At the same time, import prices increase as the UK imports higher prices, thus accounting for the increase over the three-quarters. The expectation is for the UK inflation rate to begin to level after the fourth quarter.
Looking back to Figure 1, a significant proportion of the reason for the decrease in the real GDP growth rate for the period ending in the first quarter can be explained not only by declining UK industrial output due to changes in investment following Brexit uncertainties, but more importantly, the increasing rate of the real wage decline. Following an uncertainty shock, investors naturally switch from sterling denominated assets to alternatives such as US denominated assets. Further, investors prefer to hold alternative currency in exchange for Sterling, culminating in the depreciation in sterling. As this leads to imported inflation, companies seek cheaper labour, leading to the downward pressure on wages. This wage decline has a profound effect on the real GDP growth rate as is indicated in our forecast. We show a more conclusive graphical explanation of this in figures 3 and 4 using our previous Impulse Responses to a Brexit shock.
Consider the exchange rate problem first. In order to provide a fuller explanation using our analysis, we now graphically illustrate the path of the exchange rate movements. The exchange rate is a function of the demand supply and monetary indicators (relative to the foreign or outside world). Here, as the exchange rate is taken as the Real Effective Exchange Rate which is an index of bilateral exchange rates versus the UK’s 26 major trading partners. The exchange rate is reactive to uncertainty, and thus we can add in our uncertainty indicator to our model as before. The graph shows that the path following an uncertainty shock is an immediate depreciation of the UK exchange rate for 2 quarters as shown by the solid blue line before the currency begins to moderately recover. This sharp depreciation has a profound effect on wages as shown in figure 4 which illustrates the path of the real wage rate following an uncertainty shock.
Following on from the exchange rate depreciation, the uncertainty shock shows a decline in real wages up to and after the second quarter. This pattern is one which naturally follows investment and company ‘wait and see’ policy as well as hiring cheaper labour as import prices rise. The path of the real wage decline is set to continue in the UK which it is feared will lead to further decline in the real GDP growth rate.
Uncertainty shocks and aftershocks have a variety of effects on the macro economy. The Brexit negotiations will carry uncertainty aftershocks and will continue to provide uncertainty in the UK economy far beyond their completion, and as a result, measurements of this nature will always be important.